In order to estimate likely returns and risks in the financial markets, our general approach is to identify a set of historical instances that match current conditions on a broad range of important dimensions (in practice, using an "ensemble approach" that randomizes over scores of subsets of historical data). We then look at various features of that cluster, including the average return that followed over various horizons, the deepest loss over various horizons, and the overall spread of those outcomes. In general, the clusters include a mix of both positive and negative outcomes, resulting in moderate estimates of expected return and moderate estimates of risk. In some cases, the average return across the cluster of instances is very positive, and the individual instances show few negative outcomes at all. That sort of condition justifies a very aggressive investment position. In contrast, since the late-1990's, the average returns of the clusters have been quite poor, with a preponderance of negative outcomes in historical instances having similar characteristics.

There have been a few exceptions, including the bulk of 2003 (and on the basis of the ensemble methods we presently use, the period between early-2009 and early 2010 - see Notes on Risk Management for details on our unpleasant "miss" during that period). But generally speaking, market conditions since the late-1990's have supported a defensive investment stance much more often than is typical on a historical basis. Of course, the near-zero total return of the S&P 500 since the late-1990's, coupled with two separate market losses of more than 50%, is a reflection that on average, concerns about poor return and high risk during this period have been well-placed.

In reviewing market conditions this week, what strikes me most is the pattern that emerges when we look across various horizons, from 2 weeks out to 18 months. When we examine the average 2-week outcome that has historically followed periods that cluster with present conditions, the average outcomes are negative, but not strikingly so. Specifically, the expected return is in the lowest 26% of all historical observations, but that average return is only about -1%, a figure that is overwhelmed by typical short-term noise. That's another way of saying that guessing the market's outcome over the next couple of weeks is like guessing the throw of a very slightly biased pair of dice.

But the profile starts to change significantly as we move out the investment horizon. Looking out 5 weeks, for example, the prospective return falls into the lowest 8% of historical observations. Now, this could certainly change on the basis of shifts in various market conditions, but here and now, the 5-week horizon is more defensive than we've seen in the other 92% of historical data.

Most striking, though, is what we observe on the basis of prospective drawdown (the deepest loss the market experiences within a given horizon) looking out over the coming 18 months. On that front, the present drawdown estimate is in the worst 1.5% of all historical observations.

Keep in mind the distinction between the drawdown and the return over a given period. The drawdown over an 18-month period is the deepest loss experienced by the market from the current point to the lowest point within that horizon, even if the deepest loss occurs fairly early in that window. In contrast, the return over a given period is measured from the starting point to the ending point. Importantly, once we observe conditions that associate with a significant risk of drawdown, we can almost always find some point later on that provides a better entry opportunity to accept market risk.

Elevated Markets and Drawdown Risks

The chart below identifies periods in recent years where we reported market conditions as being at least "overvalued" and "overbought" in these weekly commentaries. Those two conditions alone aren't enough, by themselves, to put the market in a "hard-negative" situation, but even those two tend to be enough to invite drawdown risk. The overvalued, overbought periods are shaded in blue on the chart below. The red lines indicate the deepest drawdown experienced by the market over the following 18 months (right scale), while the blue line charts the S&P 500 (left scale). Notably, even with weakly negative conditions - overvalued and overbought - the market has typically moved lower at some point in the next 18 months, wiping out all intervening gains. That surrender of intervening gains usually begins with a very hard and unexpected initial loss that takes out the bulk of upside progress within a period of a few days or weeks. This is a general pattern that we also see throughout market history.

Of course, our present concerns are based on a smaller and more negative subset of conditions that we've seen even less frequently - presently featuring not just "overvalued" and "overbought" conditions, but adding overbullish sentiment, modest but clear upward pressure on short-term and some longer-term yields, and an "exhaustion syndrome" (a combination of "whipsaw" conditions coupled with falling earnings yields - see Goat Rodeo ), which have historically had a particularly hostile aftermath, including a small set of historical plunges that include 1987, 2000 and 2008.

Notably, these conditions are independent of economic concerns. They are based on factors that have reliably identified elevated market risk without the necessity of concurrent economic strains. That said, while we certainly recognize the recent improvement in economic data, that improvement remains "low level" in that we continue to view the economy as vulnerable to even mild additional shocks. During mid-2011, consumption and production activity fell back, as consumers and businesses put off spending plans based on the flaring credit strains in Europe. Following the coordinated easing and 3-year liquidity operations of the ECB and other central banks, a collective sigh of relief became clearly observable in a burst of pent-up economic activity in recent months. It is still very unclear that this is a sustained or sustainable improvement, and even the latest data from the OECD leading indicators last week did not do much to ease our broad economic concerns.

From an economic perspective, then, we remain generally concerned, as the leading evidence has not improved enough to take the risk of a fresh economic downturn "off the table" - but we are also realistic about the improvement in the general trend of recent months. It may or may not be thin ice, but people are skating on it for now, and there's no denying that.

From an investment perspective, however, it's important to underscore that economic concerns are not the driver of our present defensiveness. We've seen a handoff from negative leading economic indicators to much more general "overvalued, overbought, overbullish" conditions. Either one alone is a headwind, a high-risk condition does not require both, and the vast majority of history has featured neither.

The bottom line is that near-term market direction is largely a throw of the dice, though with dice that are modestly biased to the downside. Indeed, the present overvalued, overbought, overbullish syndrome tends to be associated with a tendency for the market to repeatedly establish slight new highs, with shallow pullbacks giving way to further marginal new highs over a period of weeks. This instance has been no different. As we extend the outlook horizon beyond several weeks, however, the risks we observe become far more pointed. The most severe risk we measure is not the projected return over any particular window such as 4 weeks or 6 months, but is instead the likelihood of a particularly deep drawdown at some point within the coming 18-month period.

I'll repeat again that however one judges my decision to stress-test our hedging approach against Depression-era data in response to the credit crisis (a challenge that was responsible for our "miss" in 2009 and early-2010), it is important to recognize that present conditions in no way match those of 2009, or even 2003 (when we removed about 70% of our hedges). Even overvalued, overbought conditions have historically been enough to invite trouble down the road. When overbullish sentiment and other measures of exhaustion have also been present, the downside risks have been clearly aggravated.

Emphatically, none of these conditions have historically been sufficient to rule out further short-term market gains. Overvalued conditions alone can go on for several years; overvalued and overbought conditions together can continue for quarters; overvalued, overbought, overbullish, rising-yield conditions can continue for months; exhaustion syndromes can also extend for a few months, even though they typically resolve with deep declines over a longer horizon of about 6 months. During those intervening periods, as is clear on the chart above, the market can gain further ground. It's just that this ground is rarely durable, and the surrender of that ground tends to be both steep and abrupt.

Speculators who feel confident in their ability to time an exit are welcome to speculate. We are not speculators, and as much data as I've examined over my lifetime, I remain entirely unconvinced that such refined exits are possible. For our part, we remain defensive here. The good news, however, is that the potential for large market drawdowns also opens up the potential for significant changes in the set of investment opportunities available to us. We are eager to act on those opportunities, in proportion to the expected return/risk possibilities that emerge. Presently, the investment opportunity set remains one of the most unfavorable in history - we estimate a 4.4% annual total return for the S&P 500 over the coming decade (nominal), corporate bond yields are now at just 3.3%, the 30-year Treasury yield is at 3.2%, the 10-year Treasury yield is at 2.0%, and Treasury bill yields are at 0.1%. The Fed has been a remarkable success at starving investors of all reasonable return for the risk they are accepting, which is likely to badly misallocate capital in the process. The problem is that with valuations at present levels, the risk that investors face is greater, not less.

Market Climate

As of last week, the Market Climate for stocks remained unfavorable, reflecting overvalued, overbought, overbullish conditions, rising yield pressures, an exhaustion syndrome, and reduced but continuing economic concerns. Strategic Growth and Strategic International remain well-hedged here. Strategic Total Return continues to carry a duration of about 4.5 years in Treasuries, with only a few percent of assets in precious metals, utilities, and foreign currencies. We would view a significant change in the investment opportunity set as a very welcome development, but we remain unwilling to accept significant risk for insignificant or negative prospective return simply because of the temporary absence of better opportunities. If history is any guide, then one thing is certain - more durable investment opportunities will come. When they do, their arrival is typically announced by the abrupt destruction of preceding speculative gains.

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